Thursday, February 17, 2011

Best Buy: Time for the Ackman Rumor Again!

“The question I get most often is, what’s the next new thing that’s going to save the consumer electronics industry? And my answer is, it’s not any one single thing, but rather the connection of all the things that we have, both to each other, to the content that we love…and to be able to be mobile and move that around any place where we are.”—Michael Vitelli, EVP Best Buy, Oppenheimer Conference, July 15, 2009

The company—which navigated the consumer electronics store-wars so cannily it become the Last Man Standing among “Big Box” retailers—now watches the non-box likes of Amazon.com grow electronics and general merchandise revenues 71% in its just-ended quarter, while Best Buy’s U.S. brick-and-mortar sales actually declined in December.

All things considered, of course, this should come as no surprise, what with software, music, movies, TV shows and even video games going digital…not to mention the fact that computers have shrunk into book-sized tablets and pocket-sized smart-phones that can be ordered and delivered online, without the need to shlep to a Big Box retailer like Best Buy.

Yet Best Buy’s own online business rose only 13% in the month of December—a still far cry from Amazon’s online domestic growth in electronics.

Now, to Best Buy’s credit, the company did not become the Last Man Standing among consumer electronics chains by standing still. Indeed, ever since 1983, when it changed its name from “Sound of Music” and opened its first superstore, the company has moved ahead of trends in the business.

In fact the company’s most important—and gutsy—move came in 1989, when management shucked the commissioned-sales model of computer and TV-selling, letting consumers shop for themselves and making Circuit City’s high-pressured sales model obsolete. Furthermore, as consumer electronics became an ever-larger piece of the American home, Best Buy moved to ever-larger store formats.

One more thing Best Buy did to distinguish itself from its peers, and boost margins: it entered the private label business with both feet, creating its own Dynex and Insignia brands, whose blue (Dynex) and green (Insignia) boxes containing everything from 55 inch LED High Def TVs to clock radios and boom-boxes can be seen all around the store.

Largely as a result of those moves, Best Buy caught the previous decade’s cathode-ray-tube-to-flat-panel tsunami from start to finish.

Outside the Big Box, however, Best Buy’s moves haven’t always been so prescient.

A Fiscal 2000 “comprehensive strategic alliance” with Microsoft involving “significant co-marketing between Microsoft Network of Internet Services, BestBuy.com and Best Buy’s retail stores” was never much heard about again.

In 2001, the company paid $696 million for Musicland, “to continue its revenue growth beyond fiscal 2005,” as the 10K said at the time. Unfortunately, Musicland didn’t make it past fiscal 2004—at least under the Best Buy umbrella.

The company sold Musicland for “no cash consideration” in the summer of 2003.

By then Best Buy had also bought Magnolia Hi-Fi, with the stated goal of growing the high-end home theater purveyor from 13 stores to “up to 150 stores nationwide.” And while Best Buy stores today do indeed have Magnolia departments (in the corner near the TV displays), there were all of 8 free-standing Magnolias across the land, according to last year’s 10K.

Similarly, Best Buy bought Geek Squad in 2002, with the goal of making it “North America’s largest provider of in-home computer installation services,” and in 2005 announced plans to open 20 to 50 stand-alone Geek Squad stores “in the next 12 to 18 months.” (One of Wall Street’s Finest actually told Fortune Magazine around that time Geek Squad could earn more than a quarter-billion in operating income on a billion in sales in 2007.)

And while Geek Squad—like Magnolia—has been rolled out in Best Buy stores, the count of stand-alone Geek Squad stores was 7 as of the Fiscal 2010 10K.

In 2006 Best Buy bought Pacific Sales Kitchen and Bath Centers, saying “we expect to expand the number of Pacific Sales stores in order to capitalize on the rapidly growing high-end segment of the U.S. appliance market,” and although the Pacific Sales store count has more than doubled since then, according to the 10K, sales have not nearly kept pace.

In 2007, Best Buy spent $89 million to buy Speakeasy, an “independent broadband voice, data and IT service provider” to help make Best Buy the “one-stop shopping” destination for small business customers. And a year later the company paid a reported $121 million acquisition for file-sharing pioneer Napster “to reach new customers with an enhanced experience for exploring and selecting music and other digital entertainment products over an increasing array of devices.” A much-ballyhooed 2010 move into the video game trade-in business dominated by GameStop has submerged without much of a ripple.

Along the way, the Best Buy Big Box kept getting bigger, eventually reaching 45,000 square feet, which seemed barely big enough to hold everything in those pre-Amazon.com, pre-Internet days, when a product needed to be sitting on a shelf in order for the consumer to see it, learn about it and evaluate its strengths and weaknesses.But at least one retailer proved that a brick-and-mortar store could compete in a dot.com world.In 2001, Apple began opening retail stores that would average only 6,000 square feet, and although the move was initially dismissed by nearly every techno-commentator in Silicon Valley, by fiscal 2010 each one of those tiny stores was selling, on average, a whopping $34 million a year of Apple products.And that is roughly the same average annual sales figure as a domestic, big box Best Buy.(Anyone who has shopped at an Apple Store and a Best Buy knows that at an Apple Store, you'll be surrounded by students surfing the internet on Macs and iPads, toddlers playing games on iTouches, and slightly uncomfortable Baby Boomers talking to thin, black-shirted, ear-ringed Apple people carrying iPhones that can swipe your credit card and get you out of the store in minutes.(The Best Buy experience, by comparison, is no longer so much fun, what with all those non-commissioned "Blue Shirts," as the ex-Blue Shirt CEO himself likes to refer to them, pushing extended warranties and unwanted software on customers it formerly left alone to browse, as anybody who accidently bought the Kasperksy AntiVirus product along with their notebook computer at a Best Buy knows.)

Meanwhile, the drive to satisfy Wall Street and carry the Best Buy brand around the world led to larger moves than buying Napster, Geek Squad and the rest.The company spent $3.5 billion on one of those “return-value-to-shareholder” buybacks in 2007, when the stock traded in the $40s...good for both those who sold to the company and for—who else?—Goldman Sachs, which served as the counterparty to the accelerated share repurchase program.

More strategically, the company spent $1.1 billion in 2008 on a 50-50 joint venture with Carphone Warehouse in Europe, which has indeed helped Best Buy roll out well-staffed mobile phone desks in its own stores—although plans for a fleet of big box Best Buy stores across stodgy old England haven’t materialized as fast as Wall Street’s Finest expected.

Indeed, when the original deal was announced in May, 2008, the Carphone CEO said “we will have stores trading in 2009,” but the first UK Best Buy big box actually opened in May, 2010, and the company recently—according to press reports—backed out of a deal for its first north-east England store near Newcastle.

It may be a coincidence, but shortly after that deal fell through, Scott Wheway, CEO of Best Buy Europe, resigned his post, although he is staying with the company for a period of time. This came all of 18 months after Wheway got the job, at which time Robert Willett, then chairman of Best Buy Europe, announced the appointment by saying “Scott is the consummate retailer,” among other nice things.

Now, in case you’re wondering why Mr. Wheway’s change of position didn’t make much news, it may have something to do with Wall Street’s rumor mill.

Shortly after the Wheway news hit on the morning of February 1, a report popped up on the indispensible Briefing.com: “Best Buy shares spiked following a rumor that Pershing Square could take a position in the stock.”

Pershing Square, of course, is the hedge fund vehicle of Bill Ackman, the genius who, among other things, saw value in General Growth Properties when it had been left for dead, and helped create billions of dollars of value for his investors and General Growth shareholders at the same time.

Why an Ackman-for-Best Buy rumor got so much credence as to add nearly half a billion in value to Best Buy’s market capitalization—and wipe the Wheway resignation off the news page—probably relates to Ackman’s reputation for taking positions in real estate laden-retailers like JC Penney and Target, and then agitating for the unlocking of its value from the more mundane retail operation sitting on top of it.

Penney owns 416 of its 1,100+ stores (with 119 of those located on ground leases), as well as 3 million square feet of distribution space, 1.8 million of warehousing space, 6.5 million of direct fulfillment center space, its 1.9 million square foot home office in Plano, Texas, and 240 acres of adjacent property.

Best Buy, on the other hand, seems not so encumbered with the stuff Ackman seems to love.

According to the Fiscal 2010 10K, Best Buy owns 24 US store locations and 32 buildings on leased land, out of 1,000+ US store locations, plus 3.1 million square feet of distribution center space (out of 10 million total) and a 1.45 million square foot corporate office.So, real estate-wise, Best Buy looks to be somewhere in-between Borders Group (another Ackman investment, but one that did not work out as well as General Properties), which leased all its stores and owned only some of its headquarters building, and JC Penney.
Nonetheless, the Ackman rumor seems too good for Wall Street types to resist.

It appeared on Briefing.com back on January 5th (“Best Buy jumps on increased volume; Hearing rumors that Bill Ackman is targeting BBY”), and, in slightly different form, on January 3rd (“It was rumored that Best Buy could be seeing private equity interest.”)

And while we have absolutely no idea what view of Best Buy, if any, Ackman actually possesses, based on the once-every-four-week schedule it looks like the rumor should crop up again—especially if the kind of startling disclosures contained in the recent Bloomberg story quoted at the top are anywhere close to reality.

Here’s how the story began:

Feb. 9 (Bloomberg) -- Best Buy Co., the world’s largest consumer electronics retailer, may curtail three decades of tactical discounting and move instead to its own version of the everyday prices pioneered by Wal-Mart Stores Inc.
With Americans increasingly using smartphones to comparison shop, consumers are unwilling to wait for sales if they find better deals elsewhere, said Mike Vitelli, executive vice president and co-head of the North America division.
“We have to move rapidly in recognizing the transparency of pricing,” Vitelli, 55, said in a Feb. 7 interview at Best Buy’s headquarters in Richfield, Minnesota. Internal discussions about making the switch are at an early stage, he said.

There was more, with the kind of thought-provoking detail you don’t get in the usual quarter earnings-per-share reportage from Wall Street’s Finest:

During a Best Buy staff meeting, Vitelli was willing to say out loud: “Why do we carry inventory when we train consumers only to buy it’” on sale, said Rick Rommel, a senior vice president who helps run a unit that tests new concepts.
“If the pricing isn’t everyday, the consumers just wait,” Rommel said in an interview. “Our inventory sits and waits for that next promotional moment.”
Switching to consistent pricing would “be very powerful,” said Barry Judge, Best Buy’s chief marketing officer. “It makes our pricing much more transparent than it is today.”
Best Buy’s weekly newspaper circular would be “a whole lot easier to lay out” with prices easier for consumers to understand, Judge said.
“The prices are the prices,” he said.
The retailer is also reducing the number of items it sells to focus on products that sell well, Vitelli said. By the end of the year the company will carry fewer than 100 TV models in the average store, down from about 140 a year ago. Slower-selling products will continue to be sold online, Vitelli said.

It will be interesting to see how Best Buy handles what Bloomberg calls “the switch”—especially with all those Dynex and Insignia products sitting on Best Buy shelves in stores across America…and all those Ackman rumors sitting on trading desks across America.

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

6 comments:

Adrian Meli
said...

Jeff, good post, it is hard to imagine how Best Buy's business is not materially worse five years from now than it is today. The old argument was that the internet would canibalize Best Buy because people would go into their stores, look at tvs, and then order them online cheaper. However, it is evolved much worse than that. Now, you can go to Amazon and read reviews of tvs and sort by bestselling and end up reading from much more informed people than you meet at most retailers. Amazon has better reviews, is cheaper, and is more pleasurable to deal with. It is not easy to compete with someone maniacally focused on customers and keeping their own margins depressed to gain share. - Adrian Meli

You know TV sitcom used to make jokes about the level of product knowledge at the big Box electronic stores such as Best Buy, and the reality now is that with a few clicks of a finger I can have more product reviews, third party unbiased analysis than I will ever have at Best Buy -- moreover, I will have a much wider selection and probably reference to connected products (you know those who bought X also bought Y and Z).

The age of internet shopping is upon us, the critical mass has been reached (and the websites are now truly user friendly). Moreover, if you are able to buy a full fledge extendibles ladder on Amazon...the big box concept is dead!

I would suggest that many distribution channels will be destroyed by the internet, a few weeks ago I needed to replace a shower head, the plumber wanted to charge $700 (didn't want the job -- gave me the number for his distributor), the distributor wanted to charge me $550 (for his troubles), eventually I bought the shower head from an internet distributor for $199 (incl taxes & shipping).

For a long time the internet was a toy with the principal use to watch Po$rn and surfing. It now shrinks the distribution network and removes a huge layer of middle men for the consumer, its equivalent to dramatic price drops to the consumer.

I would not take any pity on BBY as a cursory glance at its growth in free cash flow over the last 5 years shows they've been able to weather poor capital allocation decisions (i.e., the purchase of Musicland, the stock buybacks of 2007). My concern as a BBY investor going forward would be as follows: if BBY does pursue an everyday "transparent" pricing strategy like Wal-Mart, what impact, if any, will such a strategy have on their operating margin, currently hovering around 4%? My thinking is that BBY needs to "tighten up" its cash conversion cycle by moving inventory out the door more quickly which should, in theory, boost operating cash flow. The question is, though, can Best Buy with such a strategy, compete with the likes of Wal-Mart on the low end, and Amazon.com on the high end? Given the double digit ROIC BBY has put up over the last 5 years, I would not bet against BBY's current management successfully implementing such a strategy, but I could be wrong in my opinion.